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Rating Action:

Moody's confirms South Staffordshire Water's Baa2 rating, stable outlook

14 Feb 2020

London, 14 February 2020 -- Moody's Investors Service, (Moody's) has today confirmed the Baa2 senior unsecured debt rating of South Staffordshire Water Plc (South Staffs Water). The outlook is stable.

The rating action concludes the rating review initiated on 20 December 2019, following publication by the Water Services Regulation Authority (Ofwat), the economic regulator for water companies in England and Wales, of its final determination for the forthcoming five-year regulatory period, commencing on 1 April 2020 (AMP7).

RATINGS RATIONALE

Today's rating confirmation reflects Moody's view that South Staffs Water has adequate financial flexibility to accommodate Ofwat's final determination while maintaining financial metrics in line with guidance for the current rating.

Under the final determination, South Staffs Water faces (1) a significant cut in allowed wholesale returns to ca. 2.61% real in cash terms from 2020 (on a 50:50 blended inflation basis and including a 33 bps small company premium added to the cost of debt at the final determination stage), compared with 3.6% in the current period; (2) a small reduction in total expenditure allowances compared with the company's requests; and (3) challenging but achievable performance targets. Compared with the regulator's draft determination, the final determination has materially reduced the company's exposure to the risk of cost overruns and performance penalties as well as negative revenue adjustments associated with reconciliation for performance in the current period. South Staffs Water further benefits from a conservative gearing target of net debt to regulatory capital value in the region of 66%.

The rating confirmation also considers the company's low business risk profile as a monopoly provider of water services operating under a well-established, transparent and predictable regulatory framework and the company's strong performance track record.

In its final determination, Ofwat set an allowed cash return of circa 2.61% for the wholesale activities at the start of the new period, which incorporates the regulator's decision to link half of the regulatory assets to the Consumer Prices Index adjusted for housing costs (CPIH), with the rest remaining linked to the Retail Prices Index (RPI). As the share of regulatory assets linked to CPIH grows over time, Moody's estimates that South Staffs Water will have an average allowed cash return of around 2.77% over AMP7. On an RPI-stripped basis, for comparison with the current period, allowed returns will fall to 2.11% (2.21% including retail margin) from 3.6% (3.74% including the retail margin), a roughly 40% cut. The low returns put particular pressure on companies, like South Staffs Water, which have expensive existing debt, and whose smaller size means that they access financial markets less frequently and are, thus, not able to benefit fully from lower interest rates today.

In addition, South Staffs Water faces an efficiency challenge of GBP17 million (or 13%) on enhancement expenditure, but did receive roughly GBP9 million above its business plan request on base operating and maintenance expenditure, including retail costs. The company also remains subject to a material negative revenue adjustment, largely associated with developer cost claims, of GBP9 million, albeit significantly reduced from a GBP17 million revenue cut applied at the draft determination stage.

While the company continues to be exposed to stringent operational targets, Ofwat lowered the level of stretch on a number of performance commitments. As a result, Moody's estimates that South Staffs Water could earn a small net reward of GBP1.5 million over AMP7, if it performs in line with business plan assumptions. However, Moody's also notes that the calibration of targets and incentive rates means that severe weather events could carry disproportionate downside risk.

Moody's base case scenario, reflecting the final determination, results in South Staffs Water exhibiting an Adjusted Interest Coverage Ratio (AICR) within the 1.6-1.8x range and gearing around 65-70% over the AMP7 period. These ratios are consistent with the current guidance for the company's Baa2 rating.

The Baa2 rating continues to be constrained by (1) the company's small size and relatively inflexible long-dated financing structure, which increases risk exposure in an environment of falling returns; and (2) the business risk and additional debt associated with other activities at the wider South Staffordshire Plc group, to which the current covenant package, which restricts gearing at 85% and requires an AICR of at least 1.5x, is the only protection. In this context, Moody's notes that the primary benefit of South Staffs Water's covenant package is the ring-fencing protection. Due to the lack of security and intercreditor arrangements and no explicit liquidity requirements, the covenant package does not currently provide any credit enhancement to the Baa2 rating.

RATING OUTLOOK

The stable outlook reflects Moody's expectation that South Staffs Water will maintain ratios in line with our guidance for the Baa2 rating, including gearing (measured as net debt/RCV) below 80% and AICR of at least 1.5x.

WHAT COULD CHANGE THE RATING

Moody's considers a rating upgrade of South Staffs Water's Baa2 rating unlikely due to the constraint presented by the company's wider group structure in conjunction with its covenant package. Any potential rating upgrade would require either a strengthening of the ring-fencing protections or a material improvement in the wider group's credit quality.

Conversely, the rating could be downgraded if South Staffs Water's financial metrics was likely to deteriorate, such that gearing would increase above 80%, and AICR deteriorate below 1.5x, both on a persistent basis.

Downward rating pressure could also arise from a significant increase in business risk for the sector as a result of legal or regulatory changes leading to a reduction in the stability and predictability of regulatory earnings, which is not offset by other credit-strengthening measures, or the company facing unforeseen funding difficulties.

PRINCIPAL METHODOLOGY

The principal methodology used in this rating was Regulated Water Utilities published in June 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

South Staffordshire Water Plc is the fourth-largest of six water-only companies in England and Wales by RCV, which stood around GBP380 million (including Cambridge Water) as at March 2019. The company provides water services to a population of nearly 1.3 million within an area of 1,500 square kilometres in the English Midlands and to around 0.3 million people in the city of Cambridge and the surrounding areas. For the year ended 31 March 2019, South Staffs Water reported revenues of GBP128.8 million and operating profit of GBP31.1 million.

The company is owned by South Staffordshire Plc, which is in turn owned 55.1% by long-term pension funds and institutional investors, advised and managed by Arjun Infrastructure Partners, and 44.9% controlled by Mitsubishi Corporation, through a direct 25% ownership stake and a 19% stake held by Mistsubishi UFJ Lease & Finance Company but managed by Mitsubishi Corporation.

REGULATORY DISCLOSURES

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Stefanie Voelz
VP - Senior Credit Officer
Infrastructure Finance Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Neil Griffiths-Lambeth
Associate Managing Director
Infrastructure Finance Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454

No Related Data.
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